Fannie, Freddie survival back on table

The consensus in Washington that Fannie Mae and Freddie Mac should be dismantled is weakening amid opposition from hedge funds, regional banks and others who could benefit if the companies survive in some form.

President Barack Obama and lawmakers from both parties have called for the two mortgage-finance companies to be replaced by a new U.S. housing system. While the official position hasn't changed, a bipartisan group of U.S. senators writing legislation is grappling with how to ensure that changes to Fannie Mae and Freddie Mac don't disrupt the recovering housing market.

Some Democrats said they are leery of engineering a switch that would liquidate the government-sponsored enterprises, or GSEs, leaving it to private entities to risk their own capital on home loans.

“I'm not sure that eliminating the GSEs totally makes sense, as some have suggested, and so I have an open mind on it,” Robert Menendez of New Jersey, a Democratic member of the Senate Banking Committee, said in an interview last week. His comments came after Senate Majority Leader Harry Reid, a Nevada Democrat, said in August that the companies shouldn't be dismantled.

Since they nearly collapsed during the 2008 credit crisis, the two companies have drawn $187.5 billion from taxpayers and have been considered too politically toxic to be preserved. While the U.S. holds controlling stakes, the outcome will affect private investors including hedge funds Perry Capital and Paulson and Co., which have accumulated preferred shares and have spent months lobbying for Fannie Mae and Freddie Mac to be recapitalized.

The hedge funds gained little traction in early meetings with senators such as Bob Corker, a Tennessee Republican who publicly rejected their pleas in the spring. As the legislative process advances and involves a wider group of lawmakers, some are listening to the argument that an entirely new system could risk instability in the market.

The changing atmosphere was reflected at a meeting today on Capitol Hill between congressional aides and representatives from the mortgage industry. Among questions on a list handed out by staff members of the Senate banking panel were whether parts of Fannie Mae and Freddie Mac should be spun off or sold to private investors instead of wound down, according to three people who attended. Participants were given until the end of October to respond in writing, said the people, who asked to remain anonymous because the meeting wasn't public.

Isaac Boltansky, an analyst with Compass Point Research & Trading LLC in Washington, said that until recently policymakers were engaged in a philosophical debate. Now they have to deal with the practical challenges, he said.

“The conversation is going to shift to whether it's necessary to burn down the whole house just to rebuild it, or whether there's merit in renovating it,” Boltansky said.

Driving investor hopes and the change in tone are the record profits Fannie Mae and Freddie Mac have been posting as the housing market rebounds from the worst recession since the 1930s. The companies are required to send almost all of those profits back to the Treasury. So far, they've remitted about $146 billion, which under terms of the bailout counts as a return on the U.S. investment rather than a repayment.

Shareholders including Perry Capital and Fairholme Funds Inc. have sued the U.S., charging that Treasury is expropriating the value of its investors' preferred shares in Fannie Mae and Freddie Mac. Those suits are adding urgency to lawmakers' efforts.

Fannie Mae and Freddie Mac provide liquidity to the real estate market by packaging mortgages into securities on which they guarantee payments of principal and interest. Legislative discussions have centered on replacing the companies with a government reinsurance agency as a backstop to privately financed loans that would kick in only after severe losses.

A bill authored by House Republicans that would scrap Fannie Mae and Freddie Mac and largely eliminate government involvement in the mortgage market is unlikely to come to a vote in its current form. House Majority Leader Eric Cantor, a Virginia Republican, didn't include the measure in a September memo on his legislative calendar for the remainder of the year.

Instead, the legislative vehicle is probably a bill being drafted by the leaders of the Senate Banking Committee, Democrat Tim Johnson of South Dakota and Republican Mike Crapo of Idaho. Their measure, which Johnson said they hope to introduce by the end of the year, will include elements of legislation introduced in June by Corker and Mark Warner, a Virginia Democrat, which would wind down Fannie Mae and Freddie Mac in five years.

Republicans, who have been most vocal about the need to eliminate the two companies, haven't moved publicly from their position. Even before Fannie Mae and Freddie Mac needed a government bailout, the companies gained notoriety in Washington with decades of controversy about their accounting practices and their role in fueling the housing bubble.

“I do believe the transition is going to be difficult and we've got to get it right,” Crapo said in an Oct. 9 interview. “But I also believe we should be liquidating ultimately and phasing out Fannie and Freddie and moving to some kind of new structure.”

Republicans and Democrats in general have shown little enthusiasm for a solution that would appear to reward investors more than taxpayers. Corker and Warner say it would be possible to preserve some parts or functions of the mortgage companies without benefitting shareholders.

Hedge funds aren't the only players pushing lawmakers to reconsider plans for Fannie Mae and Freddie Mac. Regional and community banks that rely on the enterprises to purchase and securitize their loans, for example, have expressed fears that they will be shut out of a new system.

“For a community bank, the process for gaining access to the secondary market would be more difficult than it is today,” under the legislative proposals introduced so far, said Camden Fine, president of the Independent Community Bankers of America.

Warner said the bill that emerges will ensure small lenders are able to securitize their loans, and that may mean preserving some of Fannie Mae's and Freddie Mac's infrastructure.

“We don't want to do anything that stymies the incredibly important role of the smaller institutions,” Warner said in an interview last week.

Other market participants, including large banks, have argued that five years isn't enough time to wind down the companies. They say it's unclear whether there's enough private capital willing to take the first-loss position on mortgages if Fannie Mae and Freddie Mac switch off their guarantees.

“As much as it's problematic in this town for people to stomach the idea that these entities are going to survive, we have to reform and recapitalize and privatize them to ensure stable credit formation during this transition to a new government guarantee,” James Millstein, CEO of Millstein and Co. and the author of a recapitalization plan for the enterprises, said during an Oct. 1 appearance at the National Press Club.

Millstein, who said he holds Fannie Mae preferred shares, is a former Treasury official who oversaw the restructuring of bailed-out insurer American International Group Inc.

Private-label securities can support about $500 billion of annual housing finance, while the U.S. housing market needs between $1.5 trillion and $4 trillion in annual financing depending on interest rate conditions, Georgetown University Law Professor Adam Levitin told the Banking Committee during an Oct. 1 hearing. A system in which the government acts as a reinsurer behind private capital could work, Levitin said.

Corker said a safe transition can be accomplished without recapitalizing Fannie Mae and Freddie Mac. He and Warner, his co-author, said that essential functions of the companies could survive in the system that they've proposed.

“Our bill outlines a very clear picture for a future state of housing finance that does not rely on the duopolies of Fannie and Freddie, but it smartly leverages the existing technology and infrastructure already built in order to help us get there,” Corker said in an email.

Kenneth Bentsen, president of Wall Street's biggest lobby group, the Securities Industry and Financial Market Association, said his members are concerned that a five-year transition period may be “aggressive.”

“There's a lot of value in the infrastructure,” Bentsen said. “The mortgage industry relies on it a great deal, investors rely on it a great deal. So while you want to move beyond the GSEs — we understand that that's the will of a majority of Congress in both parties — you don't want to throw the baby out with the bath water.”